The American Dream

I have been thinking lately in the wake of this real estate bubble, why do people buy homes. Over the past few days, I wrote down a few reasons and some brief commentary.

• At a certain age or after a life event like marriage or the birth of a child, it’s time to buy a house.

Hard to argue with someone’s emotional connection to home ownership, except to say that it is not the way I think.

• Flexibility to remodel and get exactly what you want without consulting a landlord.

I do see a benefit here in being able to customize your living space. While custom build-outs are relatively common in commercial space, rented housing is whatever you can find on the market.

• A forced savings plan

Some people are not good at saving money, and since each month you pay some principal you are effectively saving. This reason does not hold any personal relevance to me as I do save. It is analogous to the person that deliberately seeks to get an income tax refund even though it is giving an interest free loan to the government.

• Pride of ownership

Again, hard to argue with someone’s emotional connection to home ownership, so I won’t.

• A good investment

This is really just speculation on price appreciation, not that there's anything wrong with that. The long term record of housing prices does not show that it is a great investment. Yale Economist Robert Shiller calculated an average of 0.4% / year price appreciation from 1890 to 2000. Mind you, this is for a very illiquid asset with an appreciable amount of volatility.

• Buy into the myth that rent is throwing money away

When you rent you are paying for a valuable service, the roof over your head, maintenance of the property, and often utilities. You’re not throwing money away for that service any more than any other service you buy. In some markets a couple years ago, buying was much more expensive than renting even over the whole term of the mortgage. As compared to buying where you “throw away” money on interest, property taxes, and repairs.

• The types of properties available to rent are less desirable than ones to buy

Varies. I have heard that there has been an increase in single family homes in the suburbs available for rent.

• Concerned about rent increases

A fixed rate mortgage will lock in some of the expenses for housing, but don’t forget about property taxes. Those can move upward quickly in some areas.

• Tax benefit for owner occupied property

The mortgage interest and property tax deductions can help make owner occupied property make economic sense. Remember, these are below-the-line deductions in lieu of the standard deduction. So, you can get a maximum benefit of your expenses * marginal rate.

Anything I missed, please comment.

45 Percent of the World's Wealth

When I think of wealth destruction, I think of fires, floods, wars, and hurricanes. Steven Scharzman of Blackstone said “Between 40 and 45 percent of the world’s wealth has been destroyed in little less than a year and a half." Given that you'd think a meteor struck Earth or something of that scale.

The most relevant concern is the real wealth that has been destroyed. Paul Graham tells us, "Wealth is the fundamental thing. Wealth is stuff we want: food, clothes, houses, cars, gadgets, travel to interesting places, and so on. " Nominal dollars are not irrelevant altogether. If you have a mortgage, it is still due on the nominal amount you agreed to pay. Negative equity may induce people to stop paying their mortgage and the property will have to be foreclosed upon. This situation can result in inefficiencies as a result the destruction of real wealth.

I agree that some real wealth could have declined through:

• Depreciation in excess of gross investment. Left alone, wealth will decay and continual investments must be made to maintain that wealth.
• Inefficiencies in the transfer process from debtor to creditor where the collateral is damaged through poor maintenance or malice.

I certainly agree that the pace of wealth creation is slowed and that there may even be some wealth destruction, but I doubt that it 45 percent of all wealth in the world.

The fact that people paid too much for assets a few years ago, and that now the assets are worth much less does not mean real wealth is reduced. I suspect this wealth that Schwarzman talks about is from on 1s and 0s on a computer system. Your house is not any less of a house now because it would sell for a third less dollars. The 3 bedrooms, 2000 square feet, 2 car garage, granite countertops, etc. are still there for your use.

I doubt that 45 percent of the world's wealth has been destroyed with most buildings still standing that were there 2 years ago, airplanes still taking you where you want to go, and your computer accessing a global network that is better than ever.

Is it too easy?

I am actually not too concerned over the sheer number of fulfilled requests by Sprint. It appears this is the number of data points retrieved through Sprint's systems for law enforcement. So, the actual number of people that were under surveillance was likely in the thousands. With tens of millions of subscribers, this is not too shocking.

The bigger issue here is the lack of accountability for the watchers. There are legitimate law enforcement uses for GPS information, text messaging, phone calls, etc. While I think there should be a procedure for the government to acquire this information, the lack of documentation and accountability is very troubling. The temptation to spy on political opponents that have done nothing wrong except disagree with you rises when the DOJ does not answer to anyone. It is not difficult to imagine that people in power that will spy for their own personal advantage. Even now, we cannot be assured that this is not already taking place.

Links - http://paranoia.dubfire.net/2009/12/8-million-reasons-for-real-surveillance.html

http://arstechnica.com/telecom/news/2009/12/sprint-fed-customer-gps-data-to-leos-over-8-million-times.ars

"The government routinely obtains customer records from ISPs detailing the telephone numbers dialed, text messages, emails and instant messages sent, web pages browsed, the queries submitted to search engines, and geolocation data, detailing exactly where an individual was located at a particular date and time."

"The fact that federal, state, and local law enforcement can obtain communications "metadata"—URLs of sites visited, e-mail message headers, numbers dialed, GPS locations, etc.—without any real oversight or reporting requirements should be shocking, but it isn't. ""Soghoian's lengthy post makes at least two important points, the first of which is that there are no reliable statistics on the real volume and scope of government surveillance because such numbers are either not published (sometimes in violation of the legally mandated reporting requirements) or they contain huge gaps. The second point is that the lack of reporting makes it difficult to determine just how involved the courts actually are in all of this, in terms of whether these requests are all backed by subpoenas."

"However, communications or customer records that are in storage by third parties, such as email messages, photos or other files maintained in the cloud by services like Google, Microsoft, Yahoo Facebook and MySpace are routinely disclosed to law enforcement, and there is no legal requirement that statistics on these kinds of requests be compiled or published. "

Some Game Theory

I am reminded of a counterintuitive result that more people nearby will result in less action. The typical example in a game theory course is a crime witnessed by n people. As n grows, the likelihood that the police will be called actually falls. While this phenomenon has been well documented, I have recently observed a case where this is not true. An email was sent out to a mistakenly listserv. The recipients hit reply to all to inform the sender. As a few emails were sent, this took on a life of its own. Between the initial emails, replies to those emails, and emails telling people not to reply to all there were about 50 emails in all.

A couple possibilities

1. The game theory result is still correct. Where n increases, the probability of any reply falls. However, if the first reply to all is sent everybody will jump on the bandwagon.
2. This situation calls for a different set of assumptions than the typical game theory situations of shared responsibility.

It takes all kinds

I saw an article recently talking about Google's presence in Japan. It is one of the few countries they have not dominated.

"Earlier this year, Google’s splash page for Japan abandoned the company’s classic spare design and added links to YouTube, Gmail and other services — an attempt to lure Japanese users who favor sites decorated with a cacophony of text and graphics." ----NY Times

I am not sure why anyone would want a cacophony of text and graphics. It's distracting, loads slowly, uses lots of memory, and has a tendency not the render the same way across browsers, screens, etc.

Future of Journalism

The old business model for journalism is clearly on the decline as we can see from the bankruptcy filings of major newspapers. No business model is guaranteed to persist in an economy that allows creative destruction, but people's needs still need to be fulfilled in one way or another. It takes a lack of imagination to think that journalism is dead. The 20th century newspaper business model is dying for sure. I think that people still want facts to be gathered and commentators and aggregators still need a primary news gathering as support. I believe that some model will allow companies to make money by producing news whether that involves microtransactions, a separation of content and distribution (similar to ASCAP in the recording industry), or something nobody has thought of yet.

I went to a round table discussion on political journalism and I had a couple takeaways. I may turn this into a more detailed blog entry later.

• Journalism was never that well paid to begin with
• Much of what's available on the Internet, TV, etc. is aggregation or commentary rather than primary news gathering
• Newspaper model is clearly in the past. I wish the roundtable had gotten into some detail about possible business models and payment systems. At some point I will go into more depth.
• The issue with non-profit news gathering groups as a solution is that they don't care as much about interesting stories. They may cover "important" stories that nobody will listen to or read since they don't have nearly the incentive to get eyeballs.

Oh come on

Useless Features

Conversation

MC : have you ever used the web in windows to search what program opens a file type and been successful?
DR: no
DR: it's about the most useless feature
MC: i know
MC: it's laughable
DR: up there with copying a file and relying on the time estimate
MC: hahaha

This Time It's Personal Finance

I have taken some time to clarify my investment style for this blog and for myself without making any specific investment recommendations.

• Value, concentrated investing – While many seek the diversification of the full market portfolio, I speculate on a few investments I believe to be a great value. Growth companies have historically underperformed value stocks as investors systematically overestimate growth. Earnings growth regresses to the mean, and value typically is a better investment. A purely quantitative black-box strategy could evaluate the entire market and find value stocks. However, I am examining a company’s strategic position, financial statements, and conference calls. A portfolio of a small basket of investments that are in different sectors will get most of the benefits of diversification.

• International exposure – Most investors in any given country have a home bias. While there are barriers in understanding and in regulations to investing in other countries, it seems excessive. I seek to invest a high percentage of my investments outside the United States in emerging markets. In the cases where I cannot buy individual stocks, I buy exchange traded funds that give exposure to a particular country or region.

• Liquidity is not all that important – Most of my investments are fairly liquid at this point in time since I am unable to invest in private equity and venture capital. However, I am willing to make illiquid investments if I am compensated for that illiquidity. You can maintain liquidity on tap with credit lines at a very low cost to maintain.

• Leverage – At this time, I have cheap access to credit to borrow against investments in my portfolio. While leverage increases risk, I am in a great position to assume that higher risk. With a greater base of assets, my return on equity will be higher assuming my asset’s returns are greater than my borrowing rate.

Thanks to Dave Albrecht for asking me to write about my investing philosophy

We are HTC

HTC has been a major producer of smart phones for the last several years, but many of their phones barely acknowledged where their origin. I have an HTC Tytn II, which is better known has an AT&T 8925 or AT&T Tilt. HTC is now bringing its name to the foreground with an advertising campaign, "You."

I really appreciated the images and music used in the commercial. Here's the script -

It’s the first thing you see in the morning.

And the last thing you see at night.

It stresses you out.

And calms you down.

It helps you remember.

It helps you forget.

It keeps you connected.

It’s the only thing that is alway within an arms reach.

Which is why you don’t need to get a phone.

You need a phone, that gets you.

And you. And you. And you.

And we are HTC.

It seems that someone really understands how people use their phones and people's connection to their phones. HTC has such a broad line of products across price points, feature sets, and operating systems their advertisements have to be about experience not specific features, apps, and utility. (Contrast to an Iphone ad)

Corporate Speech

I recently found myself in an argument about the rights of a corporation to speak on political issues. To give some context, it was a long discussion beginning with talk of the bailouts and financial regulation and moving towards whether corporations have a right to speak and corporate personhood in general. While there was plenty of fodder for blog entries, I am addressing the corporate speech issue.

Shareholders have interests in a company doing well and sometimes regulation or tax policy is a critical issue. Shareholders and directors acting on behalf of themselves have the right to advocate for or against various issues. I think most people would agree to that proposition.

However, in order to be effective in promoting the interests of the shareholders the speech needs to be coordinated. In practice, the transaction costs are far too high not to do so and shareholders are not neccessarily aware of all the issues that are relevant. They have appointed directors to deal with that and anything else in the day to day operation the the company.

In principle, people do not lose rights when they pool their resources and appoint agents to represent them.(a corporation) "Issue" ads are exactly the type of speech that was intended to be protected. To prohibit corporate speech in favor or against policies is to tie the hands of the shareholders and effectively prevent them from promoting their interests.

Responding to Incentives

I believe that people can be intelligent consumers of health care with the right information like anything else. A big part of the problem with health care is that the true cost is not borne or known by the users of health care. While there will always be a need for catastrophic health insurance to cover unexpected events, the more frequent costs could be covered by consumers. Tax policies have encouraged "all you can eat" health care paid for by a third party. No surprise that people in this regime would consume more health care at greater and greater costs. Not only is the demand higher, there is an incentive to shift costs on to third party payers.

Given this background, I found this piece from the WSJ interesting on new websites to assist with finding pricing information for medical procedures. http://online.wsj.com/article/SB10001424052748704222704574499623333862720.html

No, you're wrong

I was not thinking about this until I saw an article about the Social Security "freeze." For those of you that don't know, Social Security benefits are indexed to inflation (the CPI). I will not get into the messy details of how the CPI is calculated, but the basic idea is that if the cost of living rises 5%, Social Security benefits will rise by 5%. For 2010, there will likely be no increase since we are currently experiencing deflation and the purchasing power of dollars is increasing. However, the law does not allow for a reduction in benefits if there is deflation. I see it again and again -- people do not understand real purchasing power versus nominal dollars.

That means a freeze in Social Security payments will translate into a drop in real purchasing power for many seniors, said Jo Wiejahn, a senior citizen in South Bend, Ind.

“Any time the ... income stays the same but everything goes up from the groceries, car maintenance — everything — you are actually going backward,” Wiejahn said. “Even though I work, the fact that my Social Security is going to stay the same is tough, because that’s basically the money I depend on.”

http://www.msnbc.msn.com/id/32544620/ns/politics-more_politics/

Actually, since there is deflation right now, everything isn't going up. Since there is deflation right now and the law prevents a reduction in benefits, the purchasing power of social security benefits is rising -- but don't tell that to Rep. Phil Hare D-ILL

U.S. Rep. Phil Hare, D-Ill., called it "unconscionable" that Social Security recipients won't get a cost-of-living increase next year.

He said he would support any congressional action aimed at reversing the decision, including introducing legislation if necessary.

http://www.qctimes.com/news/national/article_49734f92-91cc-11de-8c31-001cc4c002e0.html

In the interest of fairness, some do make the point that healthcare costs are still rising and the elderly disproportionately spend on healthcare. While this does illustrate a problem with the CPI in general (consumers have different baskets of goods they buy), my main point is that everyone needs to understand their real purchasing power, not the nominal they have.

Speculator, you say that like it's a bad thing

I guess you would say I'm a speculator. I have some assumptions about the world and I look for pricing that differs from those assumptions. If I win, I get to keep my profits. If I lose, I don't get bailed out by anyone. (The same can't be set for some major investment banks with proprietary trading arms)

Speculators have been blamed for rises in oil prices, driving down stock prices through short-selling, market crashes, etc. The reality is that we need speculators able to act on their beliefs, to buy or to sell. Politicians often judge that one price is too high or another is too low. I think it would be foolish after what we have seen over the last couple years to say that the market always get the "right" price at every point in time. However, the alternative is the government setting prices, which I have far less confidence in than the market.

A restriction on the activity of speculators would severely reduce liquidity in markets. Information would travel slower and those with the best estimates of the future would be less able to bring a market back to equilibrium.

Real Change

These are two photos I took from the Jefferson memorial. I really liked the quote in the second photo.

Newspeak

This weekend I downloaded real page turner. (And the summary)

From the summary:

The Health Choices Commissioner specifies the benefits that must be made available in each year – including a requirement that each participating plan provide one basic plan in each service area in which they operate. It is then optional for the plan to offer one enhanced and one premium plan. The differences between the three main plans (i.e. basic, enhanced and premium) are the levels of cost‐sharing required, not the benefits covered. The Commissioner shall establish a permissible range of cost‐sharing variation that is not to exceed plus or minus 10% with regard to each benefit category.

The Health Choices Commissioner sounds like Newspeak to me. We'll get the choices that the allow for us to have, no more no less.

Since reading this is clearly too much of a task for one person if you're not being paid to do it, I would be open to any insights that readers of this blog happen to have.

The Public Option

I have a healthy degree of skepticism that the public option might not compete on a level playing field with private insurers. I found a publication from the American Academy of Actuaries that explains some criteria for a public plan that would compete on a level playing field.

I just can't be too surprised

If you liked the first stimulus, you'll love the second one. Politicians, particularly Obama and Congressional Democrats are nervous that the stimulus is not enough. First, look at some basic facts and reasonable judgments.

A Few Points

A small proportion of the stimulus has been spent - A $100 billion just isn't what it used to be. In addition, a majority of the $110.3 billion was spent in the month of June. Other articles, I've seen show that even less has been spent.

Economists say that only 10 percent of stimulus dollars have been spent and the president's plan has been criticized for not creating enough jobs.

Most agree that there is a lag - The economy is a complex system and nobody expected the stimulus to work instantaneously. Given that little spending out of the total has occurred and a majority was spent last month, it is too early to know what's working. Pushing the button again won't help in the near term.

States are using the money for short-term needs - People were promised grand projects to increase efficiency and build American infrastructure. However, much of the money has been used to close short-term budget gaps.

Cash-strapped states have used federal stimulus dollars to close short-term budget gaps and avert major tax increases but generally have not directed the money toward long-term expansion, according to a new report.

I had a few other observations, but these are the most important ones that I have for right now.

How else could it have been done?

Drop it from helicopters
If you remember the great economist Milton Friedman, he proposed that we "drop money from helicopters" in the event of a liquidity trap. This bypasses the slow and often inefficient process that we face in finding "shovel-ready projects" (or the latest phrase we want to use). If individuals receive money they are limited to a few broad options to dispose of the money.

• Spend or invest
• Save
• Pay down existing debt

If you believe that deficit funded fiscal stimulus can stimulate the economy, spending or investing the money obviously helps matters. In this particular economic downturn, there are serious issues with the banking system. If individuals don't spend or invest, they can save put their money into banks. The banks would have a larger deposit base and less issues with liquidity. However, the best result may be that individuals pay down their high debt levels. Finance author and perhaps philosopher, Nassim Taleb, argues that the global economy needs $40 to $70 trillion in deleveraging.

Grant it to the States on based upon a simple formula
Much of the money is being administered by states for projects or being used to prop up state budgets. If we want to have the States administer the funding for projects or simply prop up their short-term budgets, a simple approach would be to transfer an amount calculated in proportion to population, state product, taxes to the Federal government paid by its citizens, or some other available measure. The Congress does not have a tendency to be succinct, and a stimulus bill on one a sheet of paper is not likely to happen (or at least short enough to be read).

Some combination of individual stimulus and grants to the States
Combining these two approaches should not result in a stimulus bill so long that you would fall asleep reading it. The approach that Congress actually used has not been shown to actually focus on long-term, high return investments. A quickly enacted and carried out stimulus that simplistically dropped money from helicopters to the States and/or individuals would likely pack more of a punch. (If you grant the initial premise that deficit spending will stimulate the economy)


I will be continuing to research this issue with the following sites:
Stimulus Watch
Recovery.org

Thanks for reading, tell your friends.

California IOUs

The largest banks in California including Well Fargo and Bank of America have accepted the IOUs in the past. Now, some banks have said they will stop accepting the IOUs at the end of the week.

From this, a market is arising for California IOUs. If you look on Craigslist in San Francisco, there are dozens of ads for "IOUs Wanted."

This raises a few issues

1. Is this a state-issued currency? It is used just like a currency, except that there is an explicit interest bearing feature. If it is a currency, that runs into constitutional issues.

No state shall enter into any treaty, alliance, or confederation; grant letters of marque and reprisal; coin money; emit bills of credit; make anything but gold and silver coin a tender in payment of debts; pass any bill of attainder, ex post facto law, or law impairing the obligation of contracts, or grant any title of nobility.

2. What are they worth if the state does go bankrupt? I have some idea about what happens with a corporation goes bankrupt, but I don't know much about the equivalent for a State.

3. Banks are accepting the IOUs and some may continue to accept them after this week. How do they impact the bank's capital and what does the US Treasury have to say about it?

Changes in regulations try to solve the last crisis rather than prevent a future crisis, and in large part it's the only thing that they can do. In this time of changing regulation, we should think about how difficult it is to gauge regulatory effectiveness in a complicated financial system. What I'm trying to say is that we know when something bad has happened, but how do we know when we've prevented something bad from happening through regulation?

Looking at the historical data as a guide to regulatory effectiveness is a poor guide. The structure of the economy, the financial system, and other regulations has changed substantially over the last couple hundred years and even the last 50 years in which we have data. Huge changes in communications, growth in financial products for consumers, changes in goals and execution of monetary policy, and changes in culture have left us with an system that is different than it was just a few decades ago. Using history as a guide for the regulation of today's financial institutions should be done with caution - we only have a very small sample.

Even if there are lots of regulation on financial services, people will still do things that do not make sense and recessions will still happen. We know that regulations can stifle innovation by making it more expensive or impossible to change. While the costs of regulatory compliance in terms of management time spent or legal compliance costs may be known or knowable, the cost of opportunities not pursued and chances not taken because of complicated or inflexible regulations will never be known.

On a final note, I do think there is a place for some regulation in financial markets. However, I also worry about regulations that are the equivalent of a 10mph speed limit on the interstate.

Nobody is above the law

It is easy to get the impression from many news stories and the reaction by Obama that the recent events in Honduras are something like a typical military coup. The circumstances of this case show that the military was merely enforcing the rule of law and providing force to other institutions that operate within the law.

President Manuel Zelaya brought this upon himself by his disregard for process and rule of law.
http://news.yahoo.com/s/ap/20090626/ap_on_re_la_am_ca/lt_honduras_constitution

http://blogs.tnr.com/tnr/blogs/the_plank/archive/2009/06/29/fetishizing-the-presidency.aspx
There were some particularly interesting quotes from the article above.

"Under Honduran law, soldiers are normally responsible for distributing ballots ahead of elections, but the military leadership has opposed the vote. Zelaya has fired the military chief for refusing to support the referendum and vows to ignore a Supreme Court ruling ordering him reinstated."

"Congress — led by members of Zelaya's own Liberal Party — has opened an investigation into his mental stability and could declare him unfit to govern."

"It followed a series of clearly unconstitutional moves on Zelaya's part, including his attempt to unilaterally remove the chief of the army, which, according to Honduras's Constitution, can only be done by a congressional super-majority. "

Zelaya broke the law and put himself above all other insitutions.

"Congress cannot investigate me, much less remove me or stage a technical coup against me because I am honest, I'm a free president and nobody scares me."

He believes himself above the law.

"The Supreme Court, Congress and the attorney general have all said the referendum he is sponsoring is illegal because the constitution says some of its clauses cannot be changed."

"The constitution, approved in 1982 as Honduras was throwing off two decades of nearly uninterrupted military rule, states that any politician who promotes presidential re-election will be barred from public service for 10 years."

The constitution prevents a strongman from developing at least through legal and constitutional means.

The other side of this matter is the complaints of a "rigged system" in Honduras. As in many third world countries, there are huge inequalities in power, wealth, and income. However, these moves by Zelaya do not move Honduras in the right direction. Zelaya was following the typical pattern of a dictator in the making. (much like his ally, Hugo Chavez) of undermining other institutions. This continues until arbitrary and unchecked power is vested in one man or a small group of people. The power of a charismatic leader to undermine institutions for some stated noble goal can be substantial. Sometimes this happens through the consent of an unwary people, while at other times substantial irregularities in electoral process do not reflect what the voters actually want. In either case, this power must be checked before it is too late and no other functioning institutions are left to contend with executive power. Term limits are one attempt to prevent the accumulation of power in one man or branch of government. It is inadvisable to entrust so much power to one man and one institution regardless of how noble he says his purposes are and how great some people think he is.

Leaving TARP

I'm catching up on my DealBook, and I caught this article on leaving TARP.

The repurchase of preferred stock is easy to price, but the warrants are more difficult to value. However, using Black-Scholes a reasonable approximation of the value can be made. Basically, there is enough leeway in the assumptions made about pricing and the conditions on the warrants, that the range could be very large for prices that are fair for both parties.

Chrysler Bankruptcy and Demagoguery

Some of Chrysler's creditors rightfully objected to bankruptcy plan that gave most of the company to holders of unsecured claims (the UAW) above the secured debt holders. The bankruptcy code calls for absolute priority in any Chapter 11 reorganization. In the case of Chrysler, this means that the senior secured creditors must receive at least what they would have received in liquidation before anyone else is paid. The art and science of valuation plays a key role in determining the estimated liquidation value and the value of the non-cash settlements distributed to claimants.

Politicians have used the Chrysler bankruptcy for demagoguery and seek to bypass the usual legal processes. Michigan Congressman John Dingell stated, "the rogue hedge funds that refused to agree to a fair offer to exchange debt for cash from the U.S. Treasury – firms I label as the “vultures” – will now be dealt with accordingly in court." The governor of Michigan said, "It also came in spite of a few greedy hedge funds that didn't care how much pain the company's failure would have inflicted on families and communities everywhere. Their refusal to share in the sacrifice forced bankruptcy proceedings to begin." Finally, Obama said that they were "a small group of speculators" who "endanger Chrysler's future by refusing to sacrifice like everyone else."

Ultimately, a bankruptcy that violates absolute priority based on political pressure sets a bad precedent on a couple of levels. First, it is damaging to the rule of law. The bankruptcy codes and precedents are well-established. While there are technical issues in valuation, the spirit of absolute priority is the central issue. The dissident claim holders in the form of the non-TARP lenders had every right to demand their fair share. Politicians have no right to demand that secured lenders sacrifice so that the UAW or anyone else could get a better deal. It does not matter at all that these creditors were "rogue" hedge funds or that many did not pay face value for their claims -- the rules of the game are already set for this bankruptcy. To blame "speculators" and hedge funds is nothing less than classic demagoguery. Second, the consequences in the capital markets may be far-reaching. How will debt be priced if security is meaningless in practice and determined by your favor with politicians? It is similar to the cram-downs on mortgages. It sounds like a way fix the housing markets in areas where many are under water on their mortgages, but it would be difficult to expect that mortgage rates in the long-term.

Some defend the "speculators" because of they are pension funds representing ordinary workers.

Far from being speculators, these funds represent retired public employees, including cops and teachers. The funds paid a premium to buy "secured" status, only to discover that they were politically outranked by the United Auto Workers in the White House hierarchy.
WSJ 5/21/09

This is a true statement since the financial markets affect wealth far more than direct holdings indicate. However, this cannot be the major point of the defense. It does not matter whether the claim holder is a "rogue hedge fund" or a fund for widows and orphans--the bankruptcy courts are not a place or charity. To do anything other than follow absolute priority is to ignore rule of law.

The Yield Curve is Getting Steeper

The term structure of interest rates (the yield curve) has historically been a leading indicator of economic indicator. Over the last few months, the yield curve has become much steeper. The December lows on the 30 year was 2.52% with the 3 month at basically 0. Since then the 3 month has moved up, but not by much while the 30 year has soared to over 4%. A steeper yield curve is a good sign for economy. It indicates that there will be higher interest rates due to more demand for capital. The yield curve has typically been a good indicator, but one has to wonder if the same rules apply in this situation.

MSNBC is typically a waste land, but...

Rachel Maddow on MSNBC delivered a scathing critique of a recent Obama speech. Obama criticized Bush policies on detainees, and then in the same speech he claimed the authority to do the same things as Bush. I do not watch her show, and I would probably disagree with most of her policy stands. However, she gains some credibility by applying the same standard to her guy as Bush.

http://www.youtube.com/watch?v=1uuWVHT1WUY

Social Security and Medicare

I am currently taking a financial statement analysis course, which covers a number of accounting issues that have wider implications in the economy. The adjustments to property, plant, and equipment, leases, inventories, and pensions are made by financial analysts to get closer to economic reality and the prospects of a company. With current payroll taxes and benefit schedules, there is a substantial unfunded liability that is not included in the national debt. If believe the numbers, either taxes need to go up or benefits must be reduced.

The early recipients of social security received much more than they paid into the system. When there was a huge number of works for every retiree, there was no problem with this model. However, the population is aging and fewer workers support each retiree. The excess paid to early recipients will catch up with us, and somebody has to pay in reduced benefits or increased taxes.

Under GAAP standards, the obligations of the federal government are several times the official national debt. While I'm not in the business of predicting a collapse, I have to wonder who is going to buy the bonds of such a leveraged country going forward.

A Problem Made For Bankruptcy

There is a set of laws already in place to deal with GM's bondholders, suppliers, unions, and anybody else who has a claim on the company's assets. The bonds are widely held, there are many suppliers and other obligations. In order to get all of these constituencies to the table, the bankruptcy court is the best way to settle it. The court would follow established precedent and priorities to pay out claims or reorganize the company rather than a popularity contest playing to political concerns. A successful bankruptcy reorganization will result in:

1. Creditors paid in a fair and equitable settlement in accordance with absolute priority. The ones that will make "sacrifices" will always be the ones with lower claims.
2. GM going forward with a less burdensome debt enabling the company to compete better with other automakers.

Bankruptcy allows the creditor classes to vote(1/2 in number and 2/3 in amount) on a plan that is binding to all parties, effectively solving the holdout problem. Even if a class holds out, a bankruptcy plan be crammed down.

Chapter 11 was designed to force all the claim holders together and giving nobody what they want. That's what GM needs to move on.

Trillion with a T

The national debt is increasing at a rate of over $3 billion per day. From the lows of December 18th, the 10-year and 30-year Treasury bills have risen substantially. December was a panic flight to quality that pushed the 30-year yield to 2.55%. It rose to 3.80% as the panic subsided and investors realized the supply of Treasuries in the next several years will be enormous. The Fed stepped in saying it would buy longer term treasuries which brought yields down sharply. This steep fall in yields was not sustained in the next few days. I believe that much of this is due to concern about the future rate of inflation. If the Fed sustains it's buying for too long, it will fuel inflation. China is talking about scaling back its purchases of US Treasuries. I am sure others will not be far behind.

AIG Bonuses

With the handing out of $165 million worth of bonuses to AIG executives, some are upset. In large part the reaction to this is on pure emotion and the remedy disregards respect for due process. The anger directed at Edward Liddy, the CEO of AIG, is downright absurd. He joined AIG after the disaster in the credit default market, taking a salary of $1 and compensation in equity. If there's no value left in the company, Liddy will not profit.

Only a part of AIG was part of the mess that resulted in a government bailout. AIG lost huge sums of money on credit default swaps that they wrote. Many of AIG's business units are profitable, and there is no reason why the executives that lead those businesses shouldn't receive bonuses. Since AIG is planning to sell some of its business units, it would be very unwise to push their leaders out and sell a business that is in shambles. Such a policy punishes those that had nothing to do with AIG's failures. If we still believe AIG is an investment for the government, this policy destroys the value of the investment.

The bonuses as a percentage of the bailout money received are a very small part of the total. The bonuses in question are $165 million compared to the bailout of at least $90 billion, perhaps more by now. The federal government is running a deficit of $1.7 trillion. Even if the bonuses are completely undeserved, this is no reason to invalidate contracts and throw out the rule of law.

The bill passed by the House to tax the AIG bonuses at 90% is a clear violation of the spirit of the Constitution. I am not a Constitutional scholar by any means, but this is a clear example of a bill of attainder. The text of the bill does not explicitly single out AIG or this group of executives, but the intent is clear from the words that Congressmen use.

"Our message is clear: If you won't give the bonuses back, we will tax them back," Rep. Steve Israel, D-N.Y., said at a Wednesday press conference to announce the legislation.

Taxing these bonuses at 90% reduces us to mob rule.(Should we not consider this confiscation just because they get to keep 10%). The intent of this bill is to:

1. Punish by taxing at a 90% rate
   
2. Single out a specific group of individuals
3. Impair private contract

My guess is that many of the same people that oppose Guantanamo Bay are in favor of this bill of attainder. Where is the ACLU on this one?

The Biggest Borrower in the History of the Universe

I suppose it should be no surprise that yields on the treasury bonds are rising again, particularly on the long end of the curve. In the later part of 2008, we saw a panic in every other part of the market and a bubble in Treasuries that seemed to contradict the fundamentals. The US government was the running large deficits over the last few years, and all indications are that they will get even larger. With this massive supply of Treasuries, sooner or later the prices would have to fall as there is not limitless demand for US government's promises to pay.

While a technical default is not conceivable in my mind over the term of the long bond, investors realize that the probability of increasing inflation and the spectre of unfunded social security and healthcare obligations is very real. Even the Chinese might think that there has to be other places to put their dollars.

Banks to Return TARP Funds

Not all of the banks needed a bailout, and some right now are quite insistent upon returning the TARP funds they received over the last several months. Larger banks like US Bank and Northern Trust as well as smaller ones like Iberia Bank are applying to return TARP funds. It's not just Rick Santelli that is railing against bailout. The more responsible bankers in the world do not want to foot the bill for their less responsible colleagues.

TCF Financial Corp., the Wayzata, Minnesota-based bank that never made a subprime loan and hasn’t lost money since 1995, is asking why it should help clean up the mess made by Wall Street.

“I’m kind of bitter,” said William Cooper, chief executive officer of the 448-branch bank, adding that over the years TCF has invested about $1 billion in the Federal Deposit Insurance Corp.’s fund that guarantees bank deposits. “We pay for the excesses of our competitor over and over again.”

-- Bloomberg

Some of these banks will be able to pay bank the government soon and they can run their business as they see fit in the best interest of the shareholders. After all this crisis is over, it will be very interesting to see what the new banks look like in the services they offer and their underwriting practices.

If the well-managed banks are treated in the same way as the banks with lax standards, what incentive does that leave in the future?

"Mr. President, they'll see everything, they'll see the big board!"

I use Google Analytics to acquire some aggregate information on my site. I have seen an increase in page views over the last couple weeks, which is certainly encouraging. However, the bounce rates are very high suggesting that people don't actually read my site much. The more optimistic assumption would be that they are promptly adding it to their RSS reader, which would not be tracked properly by Google Analytics. Thank you for reading my site. I will have more content posted this weekend.

Markets at Work

In some cases, the principal on loans is already being reduced by players in the market without government assistance or encouragement. For sure, there are many scams out there claiming to reduce payments and principal, but there are some legitimate negotiations taking place. Hedge funds have bought speculative mortgages and they have approached borrowers in order to make a deal.

This recent article in Bloomberg gives an example of a hedge fund that purchased a mortgage for 60 cents on the market and renegotiated the terms of the loan. The hedge funds have worked proactively to protect their investments.

"Greenberg says she warmed to NAD’s proposal after Hussion explained that the value of the house had fallen well below the amount of the loan, and that it was in the company’s interest to head off a default by reworking mortgages like hers."

A relatively small percentage of "under water" mortgages have been renegotiated so far by the free market. The Obama administration has pledged support for changes in bankruptcy law that would allow judges to "cramdown" and force changes in the terms of mortgages. This idea raises a few questions in my mind

1. Are there in fact too few reductions of principal taking places in the market? In some cases it might be most efficient to foreclose and sell the house to another investor.
   
2. What will the long-term effects of changing bankruptcy law to allow "cramdowns" on mortgages? I suspect higher interest rates and worse terms for home buyers in the future.
3. What changes in regulation could make the market-based renegotiation of mortages more efficient?

Shared Appreciation Mortgages

Realistically, some lenders will see it in their best interest to reduce the principal of outstanding mortgages. The transaction costs of foreclosing on a home and the value lost is a huge. However, reducing the principal and interest of some outstanding mortgages is an incomplete solution. It is only fair that if lenders write down principal that they participate in the upside when the house is ultimately sold. There is already a way to do this very thing, but some tax regulation stands in the way.

This keeps the loan alive, the family in their home and the property occupied and maintained. Unfortunately, the IRS can’t make up its mind whether such a transaction is an equity investment or a debt instrument, so it has created a vast body of rules before such a mortgage can be created, making the transaction costs so high that a SAM is feasible only for large commercial transactions.
-- Seeking Alpha, "Regulatory Reform: Change We Can Believe In," 2/20/09

New rules and regulations that are likely to come will try to regulate for the last crisis. It will do nothing to prevent a future crisis, and they may reduce the flexibility to avert a crisis or innovate. The greatest supporters of change seem unwilling to allow prices to change too much on certain assets, permit ownership of real estate to shift to other investors, or make individuals to accept the consequences of their over investment in real estate.

Keeping People in Their Homes

I am skeptical of plans to "keep people in their homes" by government action. First, I take issue that they were in any meaningful sense, theirs at all. In many cases, real estate was bought with little or no down payment. Sometimes interest only or negative amortization(the loan balance grows in the first years of the loan) and no equity was created for the "owner." Even when a more traditional payment structure was used, the first years of the loan accumulate very little equity in any case. The lender in many cases was always the full equity owner of the property, the "homeowner" was merely renting anyway.

Over the last year and a half, home prices have fallen nationwide and particular in California, parts of the Southwest, and South Florida. In Phoenix, the median home price is $150,000, while in recent years the median in Phoenix was $262,000. With these numbers, there is a huge percentage that have no equity in their home at all. Their option to walk away from the mortgage is valuable at this point. Due to a rising unemployment rate and many people already overextended on their mortgages people are unable or unwilling to make the payments and they are being foreclosed upon.

Inefficiencies and problems of foreclosure

1. Damage to property or poor maintenance due to an imminent forclosure (similar to an agency problem)
2. Transaction costs for selling a distressed property
3. Quickly changing neighborhoods and school systems.
   

Efficiencies of Foreclosure

1. By letting homes be foreclosed and prices fall, lets prices be set closer to where it makes economic sense, arguably
   
2. The homes won't go unused for too long. As long as prices are flexible, they will keep falling until someone buys the inventory. There are two sides to this. Someone is losing their home, but somebody else gains a home at a price compared to their income that is reasonable or an investor buys a property to rent to a "working American."

In many areas of the country, the multiple of home price to income was at astronomical levels. Even with prices down, in many places housing is still expensive relative to median incomes.

"After soaring during this decade's housing bubble, home prices recently fell back in line with what people earn -- and then kept falling." -- LA Times

Some people will benefit from this fall in prices and buy more housing.

Politicians and the media lament about falling home prices or rising gas prices. There is always a temptation to say that this price is too high or that price is too long. The response by some is "there ought to be a law." Surely, it does cause disruptions to some people, but for others they get much more affordable housing. Propping up the housing market prevents everyone from knowing what real estate is actually worth, blocking the signaling mechanism of a capitalist society.

What Happened to Lending

In the popular press and in everyday conversation we hear that banks that received TARP money are not lending. As usual, there is a grain of truth to this statement. According to Bloomberg,

"Fifty-one lenders who got TARP money reduced total loans by $92.9 billion, or 2.5 percent, in the fourth quarter from the prior quarter...Their smaller peers who didn’t apply for capital or declined cash infusions curtailed lending by $1.87 billion, or 1.3 percent. "

Some people have the impression that these banks are doing no lending or that they have sharply curtailed lending. Of course, lending is down. There is a lack of demand from credit worthy applicants and standards have undoubtedly risen. A Sandler O’Neill & Partners analyst, Kevin Fitzsimmons, recently said, “I think everyone’s standards have increased, so you’re looking tighter at a loan application and probably rejecting more than you used to.” I suppose we could go back to lending to anyone and everyone in absurd amounts, but that would just be going back to the cause of the crisis in the first place. We cannot look at 2005 and 2006 as the standard of normalcy in lending. Even throughout the 1990s there was a huge increase in credit. Who is to say what is normal?


Many will have anecdotal evidence that banks have sharply curtailed lending, but it does not stand up to reality. The Treasury department recently stated, "In sum, loan activity was resilient in the face of the worst economic downturn in decades."

"An international mathematics research team announced today that they had discovered a new integer that surpasses any previously known value "by a totally mindblowing shitload." Project director Yujin Xiao of Stanford University said the theoretical number, dubbed a "stimulus," could lead to breakthroughs in fields as diverse as astrophysics, quantum mechanics, and Chicago asphalt contracting."
http://iowahawk.typepad.com/iowahawk/2009/02/numbers-in-the-news.html

Maybe we do really need funds to research bear DNA. Certainly, some bridges to nowhere will help. I think we can all agree on that. This bill is so big that it is really is incomprehensible.

"There are 1011 stars in the galaxy. That used to be a huge number. But it's only a hundred billion. It's less than the national deficit! We used to call them astronomical numbers. Now we should call them economical numbers." - Richard Feynman, US educator & physicist (1918 -
1988)

I have serious doubts that borrowing hundreds of billions of dollars to spend is a good idea. I really don't think the Congress or Senate has any idea what investments have a positive net present value. Even if they do know, there is a temptation to get as much as possible for your district whether or not it makes sense economically. This stimulus bill was sold as a way to modernize infrastructure while putting people to work. This is a dubious reason at best, jobs are a cost. Labor is like a machine or raw material in the production process. Using that input takes it out of the economy and from another productive use. Opportunity cost, opportunity cost, opportunity cost. Parts of this bill are entitlements, which probably have no realistic end in sight. So, much of this stimulus may not be reigned in when it outlives its usefulness.

"Government programs, once launched, never disappear. Actually, a government bureau is the nearest thing to eternal life we'll ever see on this earth! " -- Ronald Reagan

Take some time to watch this speech or read the text of it.

Some skepticism about infrastructure spending

Massive infrastructure projects are being sold by the administration as a way to provide jobs in the short-term and invest for the long-term economic growth of this country. With so much money being spent at once and a belief by many that the current government will make the right decisions, we are setting ourselves up for a "lost decade."

In 1990, Japan's "bubble economy" collapsed. Like our recent economic troubles, it started in real estate. Japan's case was much more extreme in degree. In the Ginza district of Tokyo, some property went for $139,000 per square foot in 1990. Japan propped up existing banks, and banks did not recognize defaulted loans. They created "zombie banks" propped up year after year by the government and pretended they were solvent.

Japan's fiscal policy was to spend on massive public works projects to keep people employed. Airports with no airliners wanting to fly there, concrete tetrapods to prevent beach erosion that actually do the opposite, roads and bridges to nowhere, and countless other projects that did not bring Japan back to prosperity.  

Creative destruction was not allowed to work in Japan. Older firms that were no longer productive were propped up by banks, and Japan's economy was frozen. To show for itself, Japan has the highest national debt as a precentage of GDP in the industrialized world, 170%.   To think that it can't happen here is to disregard the record of inefficiency and contradictions of the US government and governments in general.

Stimulus Package

"The way I see it, the first job of my administration is to put people back to work and get our economy moving again." -- Barack Obama, 1/16/09

Voters and consequently politicians have among other biases, a make-work bias. This make-work bias misses the point of a job and how the economy works.
"The Dallas Fed economist W. Michael Cox and the journalist Richard Alm illustrate this process in their 1999 book Myths of Rich and Poor, citing history’s most striking example, the drastic decline in agricultural employment: “In 1800, it took nearly 95 of every 100 Americans to feed the country. In 1900, it took 40. Today, it takes just 3.…The workers no longer needed on farms have been put to use providing new homes, furniture, clothing, computers, pharmaceuticals, appliances, medical assistance, movies, financial advice, video games, gourmet meals, and an almost dizzying array of other goods and services.”

Since I am not an anarchist, I believe there should be some government jobs and government spending. If we are looking at the government to help create or save job, we need to look ask

1. Is this an public good that will not be produced by the market? A public park or a lighthouse is the stereotypical example. There is not a practical way to restrict access to the benefits and bill for the use of a public good.
2. If government is to provide the good or service, will it be at least as efficient as contracting it out to private enterprises?
3. Does the benefit outweigh the costs? You need to count jobs as a cost not as a benefit. Labor should be counted as a cost like a machine, raw material, or land.
4. Apart from economics, is this a constitutionally allowable activity for the Federal government?

As a practical matter with this most recent stimulus package, I have a trouble believing that this money will be well-spent. I do not believe that politicians will evaluate projects properly. There is far too much emphasis on job creation. They really need to focus on the net present value complete with opportunity costs for all the inputs. With so much money being thrown at projects, how selective will they be? I suspect we will get projects of dubious economic benefit. Ethanol, synfuels, bridges to nowhere